Will Facebook’s Wealth Boom Save California?

Facebook's IPO is expected to be one of the largest one-time wealth-creation events in history. All that new wealth is also expected to generate millions, if not billions, in tax revenues for California.

But can Facebook’s Wealth Effect rescue California from its latest budget crisis?

Not likely.

The obvious reason is that Facebook’s windfall is already baked into California’s budget. When Governor Brown announced Saturday that the state's budget deficit was suddenly $7 billion more than expected, he was already taking into account the $2 billion or so in tax revenue expected from all those newly minted Facebook millionaires and billionaires. (Zuckerberg’s federal and state tax bill alone could top $2 billion).

If for some reason the Facebook deal underperforms, or company executives hold on to their shares longer than expected, the $7 billion surprise could grow even larger.

But there’ a deeper reason Facebook can’t save California. And it has to do with one of the state’s most fundamental financial problems: an overdependence on the incomes of the wealthy.

California, like New York, New Jersey, and other high-earner states, relies heavily on personal income-tax collections of the wealthy. The top one percent of earners in California pay more than 40 percent of the state’s income taxes. In California, much of that revenue comes from capital gains from tech investors and entrepreneurs.

This works well when markets rise. But during recessions and weak market years like 2011, capital gains dry up – and so do California’s tax revenues. In 2009, capital gains collections crashed by more than two-thirds, blowing a hole in the state budget that remains today.

This reliance also makes it hard for California’s budget forecasters to predict revenues. Since the wealthy earn much of their income from stock sales, their income fluctuates wildly with markets. (See chart below.)

Personal Income Tax, Capital Gains by YearÃŠ

In $Millions

1994

$18,497

1995

$21,187

1996

$33,380

1997

$47,456

1998

$61,370

1999

$94,096

2000

$119,975

2001

$49,108

2002

$33,404

2003

$45,763

2004

$75,454

2005

$112,743

2006

$117,958

2007

$131,779

2008

$56,283

2009

$28,647

2010

$55,002

Source: California Franchise Tax Board

Sure enough, the most immediate cause of California’s current crisis is an overly optimistic projection in January that stock markets (and thus taxes from the wealthy) would keep soaring. They were wrong. So now the state is back in crisis.

Granted, Silicon Valley’s wealth may surprise on the upside in coming months. Yet Brad Williams, a former budget forecaster for the state, said that the state’s dependence on wealth derived from the stock market has made accurate forecasting more difficult.

“This super-reliance on capital gains, stock options, and non-recurring income by the top earners creates a casino-like environment for forecasting,” said Williams, now a senior partner at Capitol Matrix Consulting. “There’s a lack of precision and forecasters just say, ‘Well, why not be optimistic?”

This approach may work for Facebook investors. But not for the state of California.